What are futures?
Futures contracts, frequently referred to as “futures”, are derivative financial instruments, meaning their price is based on the value of another asset, called the underlying asset. Commodities, market indices and stocks are examples of underlying assets.
Futures are legal contracts to buy or sell a specified quantity of an underlying asset on a specific date in the future at a predefined price.
Unlike forex, futures are normally traded on organised futures exchanges, also known as futures markets.
Some of the largest futures exchanges in the world are: CME Group (USA) (the largest futures exchange in the world), National Stock Exchange of India, Eurex (Europe, with headquarters in Germany), Nasdaq (USA and Europe, with headquarters in New York City).
With the expansion of electronic trading recently, futures exchanges have become mostly electronic.
In South Africa, the JSE Derivatives Market provides professional traders and private investors with a platform to trade in futures.
How do futures work?
Futures are standardized contracts to facilitate trading on futures exchanges.
Standardization applies to, inter alia, the following aspects of the underlying asset: Unit of measurement, quantity, currency unit, quality (depending on the type of underlying asset. For instance, it could be the purity of a metal.)
In every futures contract there are two sides: The buyer, who is taking a long position, and the seller, who is taking a short position.
All futures contracts have an expiry date at which a buyer is obliged to purchase an underlying asset at a predetermined price, while a seller is bound to sell it at the agreed upon price. This differs from the spot price, which is the current market price at which an asset is bought or sold for immediate payment and delivery.
These days the most futures contracts are settled in cash after expiration, except for some commodities-related contracts, like oil, where the buyer will take delivery of the physical quantity of the asset. For example, if the contract is worth 1 000 barrels of crude oil, the buyer will have to take physical delivery of 1 000 barrels of oil.
After the initial transaction, the futures contracts can be further bought and sold on the secondary market.
Example of a futures contract.
Suppose you are interested in trading an underlying asset, which has a spot price of $2 500. You are confident that if the spot price breaks the $2 550 price level, it will continue to rise, and decide to buy a futures contract at $2 550 in two month’s time.
At the expiry date, if the asset was trading at $2 600, you could implement your futures contract to buy at the predefined price of $2 550 and make a profit. However, if the price had decreased, or never reached the $2 550 level, you would still have to pay the predetermined price of $2 550 and would suffer a loss.
Leverage and margin in futures trading
Leverage is essential in futures trading. This means you do not have to pay 100% of the contract’s value amount when you open a trade. Instead, you pay a minimal amount in advance to be able to trade a futures contract.
The minimal amount payable is called the initial margin. The amount of the initial margin will depend on the margin requirements of the underlying asset and index you want to trade.
Paying only a minimal deposit means that you are trading with leverage. For instance, through a futures contract with a margin rate of 20%, you could trade underlying assets worth twenty times more than the deposit in your account.
Futures exchanges typically use high leverage. Therefore, it is of the utmost importance that risk is calculated correctly.
Initial margins are set by the relevant futures exchange. The margin rate varies with time and is put in place to reflect the volatility and risk of the market.
The margin maintenance is important when you have entered a trade. The margin maintenance is an indication of how much money is needed to keep your position open. To give some space for your trade to develop, it is lower than the initial margin.
If losses cause your capital to decrease, with the result that you do not comply with the margin maintenance, you risk a margin call. This means your broker will request you to deposit additional money to cover the margin. If you are not able to comply, the broker will liquidate your futures position and your trade will end.
Investors can utilize futures to speculate on the direction in the price of an underlying asset, like a commodity, financial instrument or security. If investors can foresee how an underlying asset’s price will move, they can generate profits either buying that asset for less than the market value or selling it for more.
Speculators are traders who accept risk to achieve profits and without the intention of actually acquiring the underlying asset. These traders buy or sell futures with the purpose of reselling it before the expiry date.
However, speculation in futures can be very risky because there is no guarantee that prices will move in the trader’s favour. Prices moving against a trader’s position can cause substantial losses.
Futures are one of the most common derivatives used to hedge risk, meaning to transfer risk.
Futures contracts are frequently used by hedgers, who need a guarantee that they will receive a given price for an asset at a future date.
Hedging is buying or selling futures as protection against the risk of loss due to changing prices in the market.
A short hedge is utilized when you plan on selling your asset at a predefined date in the future and want to protect yourself against falling prices.
A long hedge is used when your intention is to buy an underlying asset and want to protect yourself against increasing prices.
Forex trading and futures trading
Futures can, as with other types of underlying assets, also be used to trade forex.
Forex futures operate on the same basis as other types of futures, namely a buyer and seller will enter a contract to trade one currency for another for a given price at a predetermined future date.
Forex futures can be traded at one of the numerous futures markets around the world and can also be utilized for speculation and hedging.
The prices for forex futures “are calculated by taking into account the carrying costs for the borrowing and purchase of the target currency over the life of the contract as well as the possible investment earnings of the base currency.” (FXCM)
Choosing a futures broker
Choosing the right futures broker is an important decision to make. Some of the deciding factors are:
- Fees: A competitive and transparent fee structure is essential.
- Customer support: A reliable and fast customer service will be a big advantage.
- Trading software: How good is the trading platform? What charts and technical tools are available to support you when you conduct your analyses?
Frequently Asked Questions
Is Futures trading safe?
There is a counterparty risk.
Do Futures trade 24 hours?
Most futures can be traded 24hrs a day electronically.
What is the advantage of future trading?
Greater leverage, longer trading hours & lower trading costs.
How can I make money in futures?
Keep up with trends, watch your expenses and cut your losses.
Can I sell futures before expiry?
Most traders exit their contracts before expiry date.